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A Simulation Method to Calculate Inverse-Optimum Social Marginal Welfare Weights

We propose a method to calculate implied marginal social welfare weights if the current tax-transfer system is optimal. At the optimum, the cost of providing one Euro to a specific group must equal its weighted benefit. For every percentile of the income distribution, we calculate the cost of transferring 100 Euro to individuals in that percentile. To calculate behavioral costs, we estimate a structural labor supply model and simulate labor supply reactions to these small local tax reductions. The advantage of this simulation approach is that we do not need to restrict labor supply in any way to obtain analytical solutions. For instance, the method allows for non-convex budget sets and labor supply reactions of the secondary earner. We apply the approach to Germany and find that the tax-transfer system is optimal if society is inequality averse and values one Euro for households at the 10th percentile twice as much as one Euro for households at the median. At medium incomes, implied weights for couples are higher than for singles.